Proposal to amend European Emission Trading Scheme (ETS) in context of Fit-for-55

On 14 July 2021, the European Commission ('the Commission') presented the 'Fit-for-55' climate package, a legislative package containing various proposals all aimed at the same goal: a net reduction of 55% in greenhouse gas emissions by 2030 compared to 1990 (See also our previous Stibbeblog on this subject). One of the components of the legislative package is a revision of the European Emissions Trading System (ETS), with the aim that the ETS as well should contribute to the new reduction target of 55% by 2030 to be achieved. The Commission proposes a number of amendments to the ETS Directive, including the inclusion of maritime transport in the scheme and the establishment of a separate ETS for buildings and road transport. The Commission also makes separate proposals to establish a carbon adjustment mechanism at the border and to change the amount of allowances in the market stability reserve. In this blog we discuss the proposed changes in outline. We also discuss the government's initial response to the proposals.

Proposal to amend the ETS Directive

The Commission proposes a number of changes to the ETS Directive through the Directive amending the ETS Directive. The amendments concern both new proposals and the extension of the ETS to other sectors (see below 1) and changes to the current operation of the system (see below 2). The main proposals are as follows:

1. Expansion and new elements in the ETS

- The ETS will apply to maritime transport. The inclusion of maritime transport in the ETS will require surrender of emission allowances for emissions from ships carrying out maritime transport activities. This applies to ships with a gross tonnage of more than 5,000, carrying passengers or cargo for commercial purposes (the Directive amending the ETS Directive refers to the Regulation 2015/757, on the monitoring, reporting and verification of carbon dioxide emissions from maritime transport, for this purpose). The emissions covered by the ETS proposals are emissions from operations within the EU, half of the emissions from operations between ports within the EU and ports outside the EU, and emissions arising at a berth in an EU port. The inclusion of half of the emissions between EU ports and third country ports in the ETS will increase the environmental impact compared to only emissions from operations between EU ports. The Commission also hopes that this will reduce the risk of port-diversion and relocation of transhipment activities outside the EU. Although not explicitly mentioned by the Commission, it follows from the proposal that no free emission allowances will be allocated for maritime transport. Allowances will have to be bought through auctions in order to surrender them. The obligation to surrender will be introduced gradually, with the percentage of emissions for which allowances have to be surrendered increasing from 2023 to 2026. The surrender and reporting obligation rests with shipping companies. Each shipping company falling within the scope of the EU ETS will be assigned to a Member State, with the place of registration of the company determining the Member State to be reported to. If the company is not registered in a Member State, it shall be allocated to the Member State where it had the highest number of port calls in the two previous monitoring years. The Commission shall publish a list of shipping companies covered by the ETS as from 2024. The effects of the extension of the ETS to maritime transport have been examined and mapped out at the request of the European Parliament.

- There will be a separate emissions trading scheme for buildings and road transport. To reduce emissions from buildings and road transport as well, the Commission wants to extend the ETS to these sectors. In order not to disrupt the functioning of the current ETS, a separate system will be developed for this purpose to apply from 2025 onwards. The obligations under this system will be phased in gradually. In the first year, the entities covered by this system will only be required to obtain a permit and report the relevant emissions. The entities subject to these obligations are not the ultimate emitters of the emissions. This is because there are a myriad of fuel users, such as motorists or homeowners, for whom the Commission considers that it is technically and administratively impracticable to impose the obligation to obtain a permit. The licensing obligation will therefore be imposed further up the supply chain, and is aimed at 'release for consumption of fuels used for combustion in the buildings and road transport sectors'. For the definition of 'release for consumption', the Directive amending the ETS Directive refers to Directive (EU) 2020/262 (the general arrangements for excise duty). In short, this means that the permit obligation will apply to the holding, storage, production, processing and import of fuels used for combustion in the buildings and road transport sectors. The permit requirement will thus apply, for example, to refineries producing fuels used in these sectors. Fuels for which the emission factor is zero (such as environmentally friendly substitute fuels) are not subject to the permit requirement. The scope of the buildings and road transport sectors is defined on the basis of the relevant emission sources listed in the 2006 IPCC Guidelines for National Greenhouse Gas Inventories. Only from 2026 onwards will emission allowances have to be surrendered for emissions covered by this system. The allowances in this system are not allocated for free, as is still the case under the ETS, but can only be bought in auctions. A separate market stability reserve will be established for this system and specific measures are laid down in case of excessive price increases of the relevant fuels.

- A new border carbon correction system will be introduced to reduce the risk of carbon leakage. This system was announced in the Directive amending the ETS Directive and is further elaborated in the Commission's proposed Regulation establishing a Carbon Border Adjustment Measure ("CBAM"). CBAM replaces the current system whereby companies receive free allowances for activities with a risk of carbon leakage. CBAM aims to ensure an equivalent carbon price for both domestic and imported products and thus reduce the risk of carbon leakage more effectively than free allocation of allowances. The current method weakens the pressure on the carbon price, making investments that lead to greenhouse gas emission reductions less attractive. The sectors covered by CBAM are the production of steel and iron, cement, artificial fertiliser, aluminium and electricity. Under the CBAM, importers who import these goods into the EU must purchase CBAM certificates, which must be surrendered based on the number of imported goods and associated embedded emissions (‘embedded emissions’ means all direct emissions that are released during the production of the good in question and during the production of its raw materials). The price of CBAM certificates is based on the auction price of an emission allowance. The system will be phased in gradually, with a transitional phase from 2023 to 2026 during which certain obligations within the mechanism will not yet apply. Then, by 2026, the number of free allocated emission allowances will decrease by 10% per year. After ten years, therefore, no more free emission allowances will be issued for the production of products covered by the CBAM.

2. Modification of existing elements in the ETS

- The maximum number of allowances in circulation under the current system will be reduced by 4.2% each year. The linear reduction factor is the percentage by which the maximum number of emission allowances in circulation (also called the cap) is reduced each year. Under the current ETS this factor is 2.2%. The amendment will increase this percentage so that the total number of allowances in circulation decreases at an increased rate. The lowering of the cap is intended to increase the price of emission allowances and thus give a stronger signal to companies to innovate and invest in technologies that emit less CO2. Moreover, with the entry into force of this amendment, the cap will be reduced once by a quantity of allowances that is yet to be determined. On the other hand, the cap will also be increased by allowances in the context of the inclusion of maritime transport in the ETS.

- Changes to the ETS concerning capture and storage or use of CO2. The transport by ship or truck of greenhouse gases intended for storage will be covered by the ETS. This is already the case for pipeline transport of greenhouse gases for storage. This will be extended to ensure equal treatment of the different types of greenhouse gas transported for storage. Carbon capture and storage (CCS) and carbon capture and utilization (CCU) are important activities for the Commission to help reduce CO2 emissions, as they are under the current ETS Directive. In the context of promoting CCU, which is also covered by the ETS, there will no longer be an obligation to surrender allowances for greenhouse gases emissions that are captured and utilised to become permanently chemically bound in a product and will not enter the atmosphere under normal use.

- Additional conditions for free allocation of emission allowances. Companies that have had a mandatory energy audit under the Energy Efficiency Directive must either implement the recommendations of the audit report, as long as the payback period for the relevant investments is no longer than five years, or take other greenhouse gas-reducing measures. Failure to do so will result in a 25 % reduction in the number of free allocated emission allowances.

- The maximum adjustment of the benchmark values will be increased to 2.5% from 2026 onwards. Under the ETS, one use of benchmark values is to determine how many free emission allowances companies receive. The value of the benchmark represents the number of emission rights per ton of product. The benchmark values are adjusted annually on the basis of a reduction percentage. The current maximum reduction percentage is 1.6%. With the change to 2.5%, the benchmarks can be further updated to better reflect technological progress. In the Commission's view, this will also bring the benchmark values more into line with the relevant allocation periods and better reward innovation.

Proposed changes to the market stability reserve

The Market Stability Reserve (MSR) is intended to stabilise imbalances between supply and demand for emission allowances. The MSR was established by the 2015/2018 Decision (the ‘MSR Decision’). When the MSR came into force, 900 million allowances - taken from the auction volume - were placed in the MSR. Since then, a fixed percentage of allowances has been placed in the MSR each year. The main changes to the MSR are as follows.

- The number of allowances to be placed in the MSR each year is increased. This is set out in the proposed Decision amending Decision 2015/1814 as regards the quantity of allowances to be placed in the market stability reserve until 2030. This proposal ensures that a percentage of 24% allowances (and a minimum of 200 million allowances) will be placed in the MSR each year until 2030.

- The intake rate is amended to remove the 'threshold effect'. The threshold effect occurs when the total number of allowances in circulation (TNAC) is very close to the upper limit of 833 million allowances, the limit that determines the inclusion of allowances in the MSR. In this case, one allowance more or less could determine whether or not the total quantity of allowances to be placed in the MSR is included when the threshold is reached. The uncertainty this entails may cause price volatility in the market and increase the risk of market abuse. To avoid this, a buffer is proposed in the event that the number of allowances in circulation is between 833 and 1096 million. In this case, the difference between 833 million and the number of allowances in circulation is placed in the MSR. If the number of allowances in circulation exceeds 1096 million, the normal drawdown rate of 24% is applied as discussed above.

This amendment to the MSR Decision is included in the Directive amending the ETS Directive. Other changes include the proposal to include aviation allowances in the calculation of the total number of allowances in circulation, and the setting of 400 million allowances to remain in the MSR after the remaining allowances in the MSR have been cancelled by 2023.

Dutch position on the proposals

The Commission's proposals have now been assessed by the Working Party on the Assessment of New Commission Proposals (Werkgroep Beoordeling Nieuwe Commissievoorstellen - BNC), which has presented its assessments in two so-called fiches (Fiche 9: Review of the EU ETS, review of the MSR and Fiche 13: Regulation on the Carbon Border Adjustment Mechanism). The two fiches are part of a total of 14 fiches containing assessments of Commission proposals in the context of the Fit-for-55 legislative package. The (initial) Dutch position on the proposals is included in the fiches.

Sheet 9: Revisions to EU ETS and MSR

The government is generally positive about the proposals to tighten up the existing mechanisms within the ETS. It is also positive about the extension of the system to maritime transport, but it does have some concerns, including the risk of diversion to ports near the EU, and potential avoidance through greater use of ships that fall just short of the minimum limit of 5000 gross tonnes.

The emission trading system for buildings and road traffic has also been received positively, although the government emphasises that sufficient attention must be paid to the impact of price rises on households and civil society organisations as a result of the implementation of this system. The government has asked the Commission for further substantiation of the expected price rises. In addition, the government was not convinced by the proposed plans for road traffic. According to the government, the incentive provided by the proposed new system is insufficient to bring about the required change in the composition of the vehicle fleet quickly enough. The government feels that an ambitious and early tightening of the CO2 standards for cars and delivery vans is important to spur innovation.

Finally, the government asked the Commission to provide more substantiation for the decision not to apply the amended ETS to all fossil fuels. According to the government, doing so would create a more level playing field. In the current proposal, CO2 emissions from fuel use are excluded from the system in the sectors of agriculture and horticulture, smaller industrial companies, non-road vehicles and non-electric rail transport.

Sheet 13: Regulation on Carbon Border Adjustment Mechanism

The government is positive about the proposal to introduce the CBAM and agrees with the Commission that this system could lead to a more effective way of preventing carbon leakage than the current system of free emission allowances. However, the government also notes that the proposal, in combination with the phasing out of free allowances by 2026, creates a risk of carbon leakage in export markets outside the EU. The current system of free emission allowances ensures a level playing field in both the EU and export markets; under the CBAM, this will soon change to a level playing field in the EU market only. This risk of export leakage is a point of attention which the government believes could be reduced by European subsidies.

The government is positive about the step-by-step introduction of the CBAM, but critical of the fact that, in the first few years, only direct emissions will be covered by the system. According to the government, the absence of indirect emissions from the scope increases the risk of carbon leakage for electricity-intensive sectors within the CBAM, such as aluminium production and other sectors that will be extensively electrified over time. The government requests the Commission to investigate and explain the effects of the absence of indirect emissions. Finally, the government supports the idea that the CO2 price of products from countries where CO2 reductions are realised should be deducted from the number of CBAM certificates to be issued, but is curious as to how the Commission will implement this in practice.

To conclude

The Directive amending the ETS Directive, the Regulation establishing a CBAM, and the Decision amending the MSR Decision are now before the Council, where several deliberations have taken place. Following this, the proposals still need to be approved by the European Parliament, before the way in which the ETS will expand and change is established.

In addition, we expect the ETS to change in the future as a result of the agreements made at the COP-26. Further agreement on a global emissions trading system was reached at the 26th UN Climate Summit, held this year in Glasgow. The COP-26 was largely dominated by the elaboration and finalisation of the rules to implement the Paris Agreement. These rules are included in the Paris Rulebook. Article 6 of the Paris Rulebook contains the rules for the development of a global carbon pricing system and other international cooperation in this area. It states, for example, that parties to the agreement may also achieve their national contribution to emission reductions by purchasing carbon credits in other countries or by linking emissions trading systems. There has always been much discussion about the implementation and elaboration of Article 6, for example how to avoid double counting of emission reductions (in which country will the reduction be counted?). During the COP-26, agreement was reached on avoiding double counting and further steps were taken in the development of a global emissions reduction system. Especially the latter agreements could influence the ETS in the future and possibly lead to changes in the ETS Directive.

A Dutch translation of this blog can be found here